Tax Expenditure: Hidden Costs in the Budget

A tax expenditure is any provision in the tax code that reduces government revenue by allowing certain income to be excluded from taxation, permitting deductions, or offering tax credits. Because the revenue is never collected in the first place, rather than paid out as direct spending, tax expenditures are rarely subject to the same annual appropriation and scrutiny as ordinary government programs—yet they cost the Treasury billions and distort economic incentives just as much as direct subsidies would.

Revenue Forgone Is Spending

The core insight: a tax expenditure and a direct subsidy are economically equivalent from the government’s perspective. If the government cannot collect tax on $10,000 of income because of an exclusion, it has foregone revenue. If the government then writes a check for $3,000 (at a 30% marginal tax rate) to that same household, the net effect on the budget is identical. But one appears in the tax code as a revenue loss, and the other appears on the spending side of the budget as an outlay.

Tax expenditures achieve policy goals—encouraging retirement saving, homeownership, charitable giving, green energy investment, childcare—by letting people keep more of their own money rather than by government writing them a check. The politics are seductive: politicians can claim they are “cutting taxes” rather than “increasing spending,” even though the budgetary effect is the same.

Common Examples

Exclusions from taxable income:

• Employer-provided health insurance premiums are not taxed to the employee, yet the benefit is real income. This exclusion costs the federal government roughly $200+ billion per year in forgone revenue.
• Interest on municipal (state and local) government bonds is excluded from federal taxable income, subsidizing capital-raising by state and local governments.
• Certain pension distributions and retirement account growth are tax-deferred or tax-free under IRA and 401(k) rules.

Deductions:

• The mortgage interest deduction allows homeowners to reduce taxable income by the interest paid on mortgages (up to limits). This primarily benefits higher-income homeowners with large mortgages.
• The deduction for state and local taxes (SALT) allows itemizers to reduce federal taxable income by state and local taxes paid—again, largely benefiting higher-income households.
• Charitable contribution deductions reduce the after-tax cost of giving, subsidizing nonprofits indirectly.

Credits:

• The Earned Income Tax Credit (EITC) provides a refundable credit to low- and moderate-income workers, reducing tax owed or generating refunds. This is a tax expenditure that supports work and reduces poverty.
• The Child Tax Credit provides a credit per qualifying child, effectively reducing taxes on families with children.
• R&D tax credits reduce taxes on firms that conduct research and development.

Each of these costs the government revenue. The Treasury does not receive the tax that would otherwise be owed. In accounting terms, it is a reduction in gross tax receipts.

Why Tax Expenditures Avoid Scrutiny

Direct spending programs are usually subject to annual or multi-year appropriations. Congress votes on whether to fund the program, at what level, and for how long. The program appears as a line item in the budget, is assigned a committee with oversight authority, and can be debated and defended or cut on its merits.

Tax expenditures are embedded in the tax code and are often permanent or very long-lasting. They do not require annual re-authorization; they continue unless Congress actively changes the law. They do not compete annually with other programs for resources. They do not go through the appropriations process. And because they are tax law rather than spending law, they may not receive the same scrutiny from budget committees or from the public.

A politician can vote to expand the mortgage interest deduction (a tax expenditure) and claim to be “supporting homeownership,” while simultaneously voting to cut housing assistance for the poor (a direct spending program). Both policies affect homeownership incentives and fiscal costs, but one is hidden in the tax code while the other is visible and debated.

The Size of Tax Expenditures

Taken together, tax expenditures are vast. The U.S. Treasury’s annual Tax Expenditure Report estimates the total cost of major tax expenditures at over $2 trillion per year. This exceeds the cost of Medicare, Medicaid, Social Security, or defense—yet it is not often discussed in the same way.

The largest are:

• Employer-provided health insurance exclusion: ~$200 billion/year
• Mortgage interest deduction: ~$20–30 billion/year
• Deductions for state and local taxes: ~$15–20 billion/year
• Exclusion of retirement account contributions and growth: ~$100–200 billion/year (depending on how you count deferred taxation)

Hundreds of smaller tax expenditures add up. Some are explicitly aimed at economic efficiency (R&D credits, for instance). Others are politically motivated or historical artifacts with little clear justification.

Regressivity and Fairness

Most major tax expenditures disproportionately benefit higher-income households, because those households face higher marginal tax rates and have larger incomes that itemize and use the tax benefits more fully. The mortgage interest deduction and SALT deduction largely go to households in high-tax states with expensive homes. Exclusions for retirement account contributions grow most for those who can afford to save the most.

The EITC is a notable exception: it is explicitly refundable and benefits low- and moderate-income workers. But even the refundable child tax credit phases out at higher incomes, leaving the broadest benefits for middle-class families.

Because tax expenditures are not means-tested and not subject to annual budgetary discipline, they often become inefficient tools for redistribution. They are poorly targeted compared to direct spending on, say, housing assistance for the poor or direct subsidies to low-income families. A dollar of tax expenditure typically reaches fewer poor households per dollar of revenue loss than a dollar of direct targeted spending.

Proposals for Reform

Fiscal reformers and budget hawks across the political spectrum have proposed treating tax expenditures more like direct spending—requiring annual reauthorization, capping total tax expenditures, or sunsetting provisions after a fixed period. The idea is to make the true cost of tax policy visible and to subject it to the same scrutiny as other government spending.

In practice, tax reform is politically difficult. Eliminating or cutting a tax expenditure is often framed as a “tax increase,” even if it simply closes a deduction or credit that benefits a politically powerful group. Homeowners do not want to lose the mortgage interest deduction; retirees do not want IRA/401(k) rules tightened; corporations do not want to lose R&D credits.

Some reforms have succeeded: the 2017 Tax Cuts and Jobs Act capped the SALT deduction (though this was portrayed as a tax increase despite being a revenue-raiser) and made the corporate R&D credit less generous. But wholesale tax expenditure reform remains elusive.

Tax Expenditure vs. Direct Spending: Economic Equivalence

Economically, a homeowner who receives a $3,000 annual benefit from a 30% marginal rate deduction on $10,000 of mortgage interest is in the same position as a homeowner receiving a direct $3,000 subsidy from the government. The distortions and incentives are the same. The homeowner is more likely to take out a larger mortgage or buy a more expensive house.

Yet politically and budgetarily, they look very different. The tax expenditure is “cost-free” in the sense that the government does not write a check; the Treasury simply fails to collect revenue it would otherwise collect. The direct subsidy is a line item in the budget, subject to appropriation and scrutiny.

This distinction explains why tax expenditures have proliferated: they are a politically painless way to deliver government benefits and subsidies. But from a fiscal sustainability perspective, foregone revenue is as costly as direct spending.

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